Inflation and the Stock Market: Understanding the 'Fed Model'

40 Pages Posted: 29 Apr 2008 Last revised: 28 Jun 2011

Geert Bekaert

Columbia Business School - Finance and Economics; National Bureau of Economic Research (NBER)

Eric Engstrom

U.S. Board of Governors of the Federal Reserve System - Division of Research and Statistics, Capital Markets

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Date Written: April 25, 2008

Abstract

The so-called Fed model postulates that the dividend or earnings yield on stocks should equal the yield on nominal Treasury bonds, or at least that the two should be highly correlated. In US data there is indeed a strikingly high time series correlation between the yield on nominal bonds and the dividend yield on equities. This positive correlation is often attributed to the fact that both bond and equity yields comove strongly and positively with expected inflation. While inflation comoves with nominal bond yields for well-known reasons, the positive correlation between expected inflation and equity yields has long puzzled economists. We show that the effect is consistent with modern asset pricing theory incorporating uncertainty about real growth prospects and also habit-based risk aversion. In the US, high expected inflation has tended to coincide with periods of heightened uncertainty about real economic growth and unusually high risk aversion, both of which rationally raise equity yields. Our findings suggest that countries with a high incidence of stagflation should have relatively high correlations between bond yields and equity yields and we confirm that this is true in a panel of international data.

Keywords: Fed Model, Money illusion, Equity premium, Countercyclical risk aversion, Fed model, Inflation, Economic Uncertainty Dividend yield, Stock-Bond Correlation, Bond Yield

JEL Classification: G12, G15, E44

Suggested Citation

Bekaert, Geert and Engstrom, Eric, Inflation and the Stock Market: Understanding the 'Fed Model' (April 25, 2008). Available at SSRN: https://ssrn.com/abstract=1125355 or http://dx.doi.org/10.2139/ssrn.1125355

Geert Bekaert

Columbia Business School - Finance and Economics ( email )

3022 Broadway
New York, NY 10027
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Eric C. Engstrom (Contact Author)

U.S. Board of Governors of the Federal Reserve System - Division of Research and Statistics, Capital Markets ( email )

20th & C. St., N.W.
Washington, DC 20551
United States
202-452-3044 (Phone)

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